Welcome to the March 2013 edition of The Director's Dilemma.

This month our real life case study focuses on the challenges associated with successfully taking an equity position and a board seat with a promising SME that is currently underperforming and is lacking clarity in its current governance arrangements.  

Consider: Which response would you choose and why?

Sam is an experienced manager and has worked for over twenty years in his industry. He has also sat on two not-for-profit boards and enjoys the governance role. Now he has an opportunity to buy an equity stake in a small business that has a product and service for which market demand is growing.

The business has not been growing quickly due to flat market conditions and revenue has not increased substantially as a consequence. The current owners are a husband and wife team and are tired; they have run the business for many years and want to retire.

The proposal is that Sam should purchase 40% of the company and take a seat on the board. The existing owners would retain 30% equity each and a shareholder’s agreement would stipulate that board decisions would require a 70% majority to be agreed. The current board has three members consisting of the owners and an ‘independent’ chairman who is the lawyer and a long-standing friend of the owners. The proposal is that he should remain as “he adds a lot of value and sees things we would miss”.

Sam intends not to work in the company but to be merely a shareholder and director. He has ideas for improving the growth and increasing the value of the company but wants to retain his full time employment in a larger corporation as a security measure. His employer is happy for him to take on a board seat and there is no direct competition between the two companies so Sam would have no conflict of interest; however, Sam’s boss, who is a friend and mentor to Sam, is uneasy and has suggested that Sam could find himself outmanoeuvred in the boardroom and overcharged for his equity. Sam is appreciative of the counsel but believes the shareholder agreement protects his interests. He would like to discuss board dynamics with the current owners but they seem not to be interested as they say the Chairman handles all the compliance and they just run the business so there is nothing to worry about.

How should Sam handle this issue?

Doug’s Answer

Owning part of an SME is much more than an equity purchase and a board position. High level strategic and governance oversight is not enough; it takes a more ‘hands-on’ involvement.

The owners have realised they have had enough. Under the current proposal there is little in the way of resolving the typical SME succession dilemma; specifically:

  • Who has the skill and energy to ultimately take control and drive the business?
  • How to extract full value for the business which substantially funds retirement?

The board risks stalemate and conflict in decisions with a Chair aligned with current owners. Not a good outcome for the business, Sam or the current owners.

For this to be a win / win for everyone, an agreed succession plan should be part of Sam’s due diligence process along the following lines:

  • Sam’s intentions, post current-owners succession, should be clarified and agreed
  • The appointment of an independent chair and an independent director experienced in the same industry should be agreed
  • Untapped management talent existing within the business and a skilling, education and promotion program outlined
  • Recruitment program for management where gaps are identified
  • Current owners agree to an Employee Stock Ownership Plan (ESOP) where appropriate
  • Key client and supplier relationships transition to the wider management team.

Sam should further protect his minority interests by holding pre-emptive rights to purchase the remaining shares should they be on offer, notwithstanding the ESOP mentioned above.

By clarifying all the stakeholders’ intentions and aspirations, the business presents a unified front with management, the board and shareholders “singing from the same songbook”.

Doug Jardine provides consulting services to owner operated businesses and boards and is based in Sydney.

Julie’s Answer

There is more to a board than compliance. Managers accustomed to running things as they see fit whilst relying on a lawyer to put together a semblance of compliance at board level are not going to make good board colleagues. Sam has some good ideas but unless they are also in the shareholder agreement (with dates and budgets) they will likely never get implemented.

Already the board is set for deadlock whenever the existing directors disagree with Sam. The 70% required for decision-making is a nonsense as Sam will find he either has to conform to the wishes of a husband and wife team or try to split them. They might as well stipulate 100% consensus as that is all that will work in the circumstances. It is also a pretty good way to run a board.

I usually hate quasi-equity as it tends to complicate matters but Sam could look into having a preference share which is repayable as debt and converts to equity only when the strategy reaches certain milestones.

What he most needs to do is sit down with the current owners and talk, long, hard and deep, about what this company is really supposed to achieve. It looks as if it has always been supposed to provide a certain lifestyle and income for the owners. But what about the future? What do they now want the company to be?

If they can agree on a vision and set aside enough of Sam’s investment to fund the new actions that must be taken to achieve the vision, then they may be able to grow the company to a stage where a profitable exit is achievable. If they can’t agree on exactly what the vision is and how they will work to achieve it – Now – In detail – Sam should not invest.

Julie Garland McLellan is a practising non-executive director and board consultant based in Sydney, Australia.

Simon’s Answer

Sam takes an equity share to help grow the company (future nest egg). The owners (husband and wife) want to retire and secure as much money as possible from the asset sale (nest egg right now). Neither party wants any ongoing operational involvement - what is this deal really about? Are the owners serious in selling or grabbing equity dollars?

The 70% rule subjugates Sam’s rights and restricts the potential for business improvements but also terrifyingly entrenches the owners’ current policies, practices and procedures. A resolution to change anything requires the support of Sam, the Chairman (even if he/she places director duties ahead of friendship) and one of the owners – good luck with that.

There needs to be far more discussion by all parties about the fundamentals of this deal before it proceeds any further.

Sam is a minority shareholder with a Shareholders’ Agreement (SA) that lacks rigour, inclusion of, and agreement on, significant matters. The SA affords Sam no rights protection, no restriction on changes in each owner’s equity or share ownership, no restraint of trade restriction on the owners once retired and no provisions for breaking deadlocks e.g. mediation which will be inevitable given the 70% rule.

There is no guarantee that the owners will be unified on either the quantum or timeframe for retirement and the SA needs to reconcile that fact. The owners (or one of them) could just sell the remaining 60% (30%) to another party or give the shareholding to their beneficiaries. What is the agreed owner exit strategy and succession plan? There is no first right of refusal (including terms) for Sam to buyout one or both owners.

What happens if one or both owners prematurely die/separate or become incapacitated? What happens if Sam dies or is incapacitated or simply wants to get out? These all need to be included in the SA with trigger events established, agreed timeframes and pre-calculated quantum.

Now is the time to construct a rigorous SA, if any party baulks now, better to establish that at the outset before the dollars are committed. If Sam acts in haste, he/she can repent at leisure.

Simon Pinnock is  a professional and practising non-executive director and Board consultant. He is based in Melbourne, Australia.

Disclaimer

The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling. Names and some circumstances in the case study have been changed to ensure anonymity. Contributors to this newsletter comment in the context of their own jurisdiction; readers should check their local laws and regulations as they may be very different.

What's new

Combined Assurance

Book review – Combined Assurance; Risk is everywhere in a corporation so it seems odd that assurance is concentrated on the financial systems to the practical exclusion of everything else. This little book is a well-researched wake-up call, “It isn’t necessarily so!” The authors use real life case studies to illustrate how different organisations give their boards a holistic approach to governance. Unlike most audit reports it is well written, clear and action oriented. I am hoping it will go viral. Available at Amazon.

 

Inspirational quote –

"Nothing else can quite substitute for a few well-chosen, well-timed, sincere words of praise.  They're absolutely free-- and worth a fortune."

~Sam Walton

As directors it is easy to focus on our oversight and control roles; our motivation and creative roles need to balance that focus if we are to add true value (and let’s face it – Sam Walton new about creating value). If you would like to subscribe the service is run by Darren La Croix at: http://365inspirationalquotes.com/.

Presenting to Boards – Last month I did a public version of my popular presenting to boards workshop. I thoroughly enjoyed meeting the participants and envy their boards for having such dedicated and hardworking executives reporting to them. Feedback was overwhelming and I will be doing it again. The next few workshops will be delivered in-house. I am happy to talk to you if you are interested in organising either a public or private workshop.

This newsletter – If you have any ideas for improving the newsletter please let me know. If you are reading a forwarded copy please visit my website and sign up for your own subscription.

Suggestions for dilemmas – Thank you to all the readers who have suggested dilemmas. I will answer them all eventually.

Farewell until the next issue (due 1 April 2013).

Enjoy governing your corporations; we are privileged to do what we do!

Best regards


Julie